MODULE 19Computing Gain or Loss

on Disposition of Assets

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1. Computing gains and losses1. Computing gains and losses

2. Basis considerations2. Basis considerations

3. Installment sales3. Installment sales

Computing Gains and Losses

Key Learning Objectives

The gains and (losses) formula Applicable law Amount realized Adjusted basis

The Gains and (Losses) Formula

Sales priceSales price

-Selling expenses-Selling expenses

Amount realizedAmount realized

-Adjusted basis-Adjusted basis

Realized gain (loss)Realized gain (loss)

-Deferred gain (loss)-Deferred gain (loss)

Recognized gain (loss)Recognized gain (loss)

Applicable Law

The gain or loss from the sale of property The gain or loss from the sale of property Determined by the law in force at the Determined by the law in force at the

date of saledate of sale Depreciation adjustments reduce basisDepreciation adjustments reduce basis

Determined by the law in force at the Determined by the law in force at the time the property is acquiredtime the property is acquired

Amount Realized

Sum of Sum of Any money received Any money received Plus FMV of property received Plus FMV of property received Less any selling expensesLess any selling expenses

Adjusted Basis Uncovered Cost of the AssetUncovered Cost of the Asset

Original cost basisOriginal cost basis Minus cost recoveries Minus cost recoveries Plus improvementsPlus improvements

Basis ConsiderationsBasis Considerations

Key Learning Objectives Recovery of capital doctrine Determining cost basis Cost basis factors Gift basis Property acquired from decedent Property converted from personal use

Adjusted Basis Determined by

How acquiredHow acquired PurchasePurchase Gift Gift InheritedInherited

Basis Determined by Purchase

PurchasePurchase Cash/FMV of property receivedCash/FMV of property received Debt assumptionDebt assumption Non-deductible improvementsNon-deductible improvements

Basis Determined by Gift

Note: D= doner; D'e = donee; Date of gift = DOGNote: D= doner; D'e = donee; Date of gift = DOG General rule if FMV General rule if FMV >> basis at DOG basis at DOG

Use D's basis and Use D's basis and Adjust for gift taxes Adjust for gift taxes

If FMV < basis at DOG see special rules If FMV < basis at DOG see special rules

Basis Determined by GiftAdjustment for Gift Taxes PaidAdjustment for Gift Taxes Paid

D = doner; D'e = donee; DOG = date of giftD = doner; D'e = donee; DOG = date of gift Gift taxes are paid by DGift taxes are paid by D Gift taxes are based on FMV at DOGGift taxes are based on FMV at DOG Adjustment to D’e basis only if Adjustment to D’e basis only if

FMV > basis at DOGFMV > basis at DOG D’e gets gift taxes relating to appreciationD’e gets gift taxes relating to appreciation

[FMV- basis][FMV- basis]

FMVFMV

In Class Exercise: Adding Gift Taxes to Basis

D = doner; D'e = donee; DOG = date of giftD = doner; D'e = donee; DOG = date of gift At DOG At DOG FMVFMV = $17,000 = $17,000 D’s basisD’s basis = 13,500 = 13,500 Gift tax Gift tax = 2,000 = 2,000 Calculate D’e basisCalculate D’e basis

Solution--In Class Exercise: Adding Gift Taxes to Basis

Property is appreciated at DOGProperty is appreciated at DOG So start with adjusted basis of $13,500So start with adjusted basis of $13,500 Add % of gift taxes relating to appreciation Add % of gift taxes relating to appreciation

$412$412 Gift taxes x (FMV - AB) ÷ FMVGift taxes x (FMV - AB) ÷ FMV $2,000 x ($17,000 - $13,500) ÷ $17,000$2,000 x ($17,000 - $13,500) ÷ $17,000 Total basis to D'e = $13,912 (Total basis to D'e = $13,912 ($13,500+$412$13,500+$412))

Basis Determined by GiftFMV < Basis at DOGFMV < Basis at DOG

D = doner; D'e = donee; DOG = date of gift No adjustment for gift taxes Basis (AB) determined when D’e sells If used by D’e and subject to

depreciation, use FMV at DOG

Basis Determined by GiftFMV < Basis at DOGFMV < Basis at DOG

D= doner; D'e = donee; DOG = date of giftD= doner; D'e = donee; DOG = date of gift Sold for Sold for

>> D's basis then AB = D's basis D's basis then AB = D's basis < FMV at DOG then AB = FMV at DOG< FMV at DOG then AB = FMV at DOG < D’s basis BUT > FMV at DOG< D’s basis BUT > FMV at DOG

AB = Amount realizedAB = Amount realized No gain/loss recognized to D’eNo gain/loss recognized to D’e

In Class Exercise: Gift Basis FMV < Basis at DOG FMV < Basis at DOG

D = doner; D'e = donee; DOG = date of giftD = doner; D'e = donee; DOG = date of gift At DOG: AB = $12,000 FMV = $10,000At DOG: AB = $12,000 FMV = $10,000 D’e sells at a later date for: D’e sells at a later date for:

CaseCase A A B B C C

AR = $13,000 $11,000 $9,000AR = $13,000 $11,000 $9,000 What is adjusted basis in each case?What is adjusted basis in each case? What is total gain realized?What is total gain realized?

In Class Exercise: Gift Basis FMV < Basis at DOG FMV < Basis at DOG

At DOG: AB = $12,000 FMV = $10,000At DOG: AB = $12,000 FMV = $10,000

CaseCase AA BB C C

AR = $13,000 $11,000 $ 9,000AR = $13,000 $11,000 $ 9,000

AB = AB = 12,000 11,000 10,00012,000 11,000 10,000

GL = $GL = $ 1,000 0 (1,000) 1,000 0 (1,000) Note that you would plug any basis for AR Note that you would plug any basis for AR

between $10,000 and $12,000between $10,000 and $12,000

Conversion From Personal Use

Follow rules similar to gift rulesFollow rules similar to gift rules If FMV > A/B use A/BIf FMV > A/B use A/B If FMV < A/B use FMV If FMV < A/B use FMV

In Class Exercise: Conversion from Personal Use

John has an automobile used 100% for John has an automobile used 100% for personal purposes for two yearspersonal purposes for two years

He converts it to 100% business use whenHe converts it to 100% business use when A/B = $16,000A/B = $16,000 FMV = $8,500FMV = $8,500 What is John’s basis for business purposes?What is John’s basis for business purposes?

Solutions: In Class Exercise: Conversion from Personal Use

He converts it to 100% business use whenHe converts it to 100% business use when A/B = $16,000A/B = $16,000 FMV = $8,500FMV = $8,500 John uses $8,500 since FMV is lower than John uses $8,500 since FMV is lower than

A/B when the property is convertedA/B when the property is converted The $7,500 decline in value is considered to The $7,500 decline in value is considered to

be a non-deductible personal expenditurebe a non-deductible personal expenditure

Basis Determined by Inheritance

Use value reported on estate’s tax returnUse value reported on estate’s tax return Generally FMV at date of death (DOD)Generally FMV at date of death (DOD) Estate may choose to use alternative Estate may choose to use alternative

valuation datevaluation date FMV 6 months after DODFMV 6 months after DOD

Installment Sales

Key Learning Objectives Eligible sales Ineligible sales Mandatory reporting Gain reported Problem areas

Installment Sale

At least one payment is received after the At least one payment is received after the close of the tax year in which the close of the tax year in which the disposition of the asset occursdisposition of the asset occurs

Ineligible Sales Dealer disposition of property held for sale Dealer disposition of property held for sale

to customersto customers Gains relating of the recapture provisions of Gains relating of the recapture provisions of

§1245 and §1250§1245 and §1250 Stock or securities traded on an established Stock or securities traded on an established

securities marketsecurities market Property of any kind regularly traded on an Property of any kind regularly traded on an

established marketestablished market

Mandatory Reporting Unless Election Out

Any sale that is covered by the definition of Any sale that is covered by the definition of an “installment sale”an “installment sale”

Must elect out of the installment method to Must elect out of the installment method to avoidavoid

Election out attached to a timely tax returnElection out attached to a timely tax return Entire gain included in income for the Entire gain included in income for the

taxable yeartaxable year

Consequences of Electing Out of Installment Method

Cash basis amount realizedCash basis amount realized Money and FMV of propertyMoney and FMV of property

Accrual basis amount realizedAccrual basis amount realized Money and FMV of propertyMoney and FMV of property Face value of any obligation receivedFace value of any obligation received

Installment Method Gain Reported As Cash Collected Gross profit = A/R - A/BGross profit = A/R - A/B Gross profit percentage =Gross profit percentage =

Gross profit ÷ total contract priceGross profit ÷ total contract price Gain recognized = Gain recognized =

Gross profit percentage x am’t receivedGross profit percentage x am’t received Ratio applied to payments received in the Ratio applied to payments received in the

current periodcurrent period

In Class Exercise: Gain Reported on Installment Sale

Mary agrees to sell for $500,000Mary agrees to sell for $500,000 Land for which she paid $300,000 Land for which she paid $300,000 She will receive $100,000 a year for She will receive $100,000 a year for

5 years5 years Interest will be paid at the required rateInterest will be paid at the required rate How much gain will she recognize each How much gain will she recognize each

yearyear??

Solution: In Class Exercise: Gain Reported on Installment Sale

Gross profit = A/RGross profit = A/R - - A/BA/B $200,000 $200,000 = $500,000 -= $500,000 - 300,000300,000 Gross profit percentage =Gross profit percentage =

gross profit ÷ total contract gross profit ÷ total contract priceprice

40% = $200,000 ÷ $500,000 40% = $200,000 ÷ $500,000

Solution: In Class Exercise: Gain Reported On Installment Sale

Gross profit percentage = 40%Gross profit percentage = 40% Amount received each year = $100,000Amount received each year = $100,000 Gain recognized each year = $40,000Gain recognized each year = $40,000

Gross profit percentage x am’t receivedGross profit percentage x am’t received

40% x $100,00040% x $100,000 Total gain recognized is $200,000Total gain recognized is $200,000

$40,000 x 5 $40,000 x 5

In Class Exercise: Gain Reported on Installment Sale & §1250

Gains associated with depreciation cannot Gains associated with depreciation cannot be deferred through an installment salebe deferred through an installment sale

How would Mary’s gain recognition change How would Mary’s gain recognition change if the property she sold was a building if the property she sold was a building ANDAND

$50,000 of the gain is §1250 recapture?$50,000 of the gain is §1250 recapture?

Solution: In Class Exercise: GainReported on Installment & §1250

Gross profit = A/RGross profit = A/R - - A/BA/B $200,000 $200,000 = $500,000 -= $500,000 - $300,000$300,000 BUT $50,000 is recognized immediately so BUT $50,000 is recognized immediately so

gross profit is reduced to $150,000gross profit is reduced to $150,000 Gross profit percentage =Gross profit percentage =

Gross profit ÷ total contract priceGross profit ÷ total contract price 30% = $150,000 ÷ $500,000 30% = $150,000 ÷ $500,000

Solution: In Class Exercise: GainReported On Installment & §1250

Gross profit percentage = 30%Gross profit percentage = 30% Amount received each year = 100,000Amount received each year = 100,000 Gain recognized each year = 30,000Gain recognized each year = 30,000

Gross profit percentage x am’t receivedGross profit percentage x am’t received

30% x $100,00030% x $100,000 Total gain recognized is $200,000Total gain recognized is $200,000

$30,000 x 5 + $50,000$30,000 x 5 + $50,000

Installment Method Problem Area: Imputed Interest

If the contract does not specify an interest If the contract does not specify an interest rate equal to the applicable federal raterate equal to the applicable federal rate

Then interest will be imputed at that rateThen interest will be imputed at that rate

Problem Area--Related Party Sales

Sale between related partiesSale between related parties Spouses, children, grandchildren, and parentsSpouses, children, grandchildren, and parents Controlled corporation, partnership, trust, estateControlled corporation, partnership, trust, estate

Normal rules apply, unless Normal rules apply, unless Property is depreciable or Property is depreciable or Purchaser resells the property before payment of the Purchaser resells the property before payment of the

original sales priceoriginal sales price Rules can be avoided if the taxpayer can establish (to the Rules can be avoided if the taxpayer can establish (to the

Secretary’s satisfaction) that tax avoidance was not the Secretary’s satisfaction) that tax avoidance was not the motive for the transactionmotive for the transaction

Transferring an Installment Obligation

Sale, gift, or other transfer of the installment Sale, gift, or other transfer of the installment obligationobligation

Unreported gain may be reported at the time Unreported gain may be reported at the time of transferof transfer

Difference between Difference between Basis in the obligation and Basis in the obligation and Amount realizedAmount realized

Fair market value of the obligationFair market value of the obligation

Basis in Obligation

Excess of the face value of the obligation Excess of the face value of the obligation over an amount equal to the income which over an amount equal to the income which would be returnable were the obligation would be returnable were the obligation satisfied in fullsatisfied in full

Interest on Deferred Taxes

Require the taxpayer to pay interestRequire the taxpayer to pay interest Only required if the sales price of the Only required if the sales price of the

property exceeds $150,000property exceeds $150,000 Obligations from all such sales that arise Obligations from all such sales that arise

during and are outstanding at the end of the during and are outstanding at the end of the tax year exceed $5,000,000tax year exceed $5,000,000

Gains associated in excess of $5,000,000Gains associated in excess of $5,000,000